Welfare Effects of Monopoly

question will be taken up in a later chapter.However,considerations of public welfare and efficiency should be central to regulators’ concerns.

WELFARE EFFECTS OF MONOPOLY

Another approach to evaluating the relative merits of firms in perfectly competitive industries against those of a monopoly is by employing the concepts of consumer surplus and producer surplus.

CONSUMER SURPLUS

Consider Figure 8.13,which depicts the case of the perfectly competitive market.The area of the shaded region in the diagram 0AEQ* represented the total benefits derived by consumers in competitive equilibrium.Total expenditures on Q* units,however,is given by the area 0P*EQ*.The difference between the total net benefits received from the consumption of Q* units of output and total expenditures on Q* units of output is given by the shaded area 0AEQ* - 0P*EQ* = P*AE. Consumer surplus is given by the shaded area P*AE.Consumer surplus is the difference between what consumers would be prepared to pay for a given quantity of a good or service and the amount they actually pay.The idea of consumer surplus is a derivation of the law of diminishing marginal utility.The law of diminishing marginal utility says that individuals receive incrementally less satisfaction from the consumption of additional units of a good or service and thus pay less for those additional units.Thus,in Figure 8.10,consumers are willing to pay more than P* for the first unit of Q,but are prepared to pay just P* for the Q*th unit.

Definition:Consumer surplus is the difference between what consumers are willing to pay for a given quantity of a good or service and the amount

FIGURE 8.13 Consumer and producer surplus.

that they actually pay.Diagrammatically,consumer surplus is illustrated as the area below a downward-sloping demand curve but above the selling price.

PRODUCER SURPLUS

Consider,again,Figure 8.13.Recalling that the firm’s supply curve is the marginal cost curve above minimum average variable cost,the total cost of producing Q* units of output is given by the area 0BEQ*.Total revenues (consumer expenditures) earned from the sale of Q* units of output is given by the area 0P*EQ*.The difference between the total revenues from the sale of Q* and the total cost of producing Q* (total economic profit) is given by the shaded area 0BEQ* - 0P*EQ* = BP*E.The shaded area BP*E is referred to as producer surplus.Producer surplus is the difference between the total revenues earned from the production and sale of a given quantity of output and what the firm would have been willing to accept for the production and sale of that quantity of output.

Definition:Producer surplus is the difference between the total revenues earned from the production and sale of a given quantity of output and what the firm would have been willing to accept for the production and sale of that quantity of output.

PERFECT COMPETITION

It is often suggested in the economic literature that perfect competition is the “ideal”market structure because it guarantees that the “right” amount of a good or service is being produced.This is because the profitmaximizing firm will increase production up to the point at which marginal revenue (price) equals marginal cost.In this context,the demand curve for a good or service is society’s marginal benefit curve.In a perfectly competitive market,output will expand until the marginal benefit derived by consumers,as evaluated along the demand function,is just equal to the marginal opportunity cost to society of producing the last unit of output.This is illustrated at point E in Figure 8.13.A voluntary exchange between consumer and producer will continue only as long as both parties benefit from the transaction.In the long run,perfectly competitive product markets guarantee that productive resources have been efficiently allocated and that production occurs at minimum cost.

Another way to evaluate a perfectly competitive market structure is to examine the relative welfare effects.Point E in Figure 8.13 also corresponds to the point at which the sum of consumer and producer surplus is maximized.The reader will note that no attempt is made to moralize about the relative virtues of consumers and producers.Perfect competition is consid-

ered to be a superior market structure precisely because perfect competition maximizes total societal benefits.

MONOPOLY

If it is,indeed,true that perfect competition is the “ideal”market structure because it results in the “right”amount of the product being produced, how are we to assess alternative market structures? It is,of course,tempting to condemn monopolies as avaricious,self-serving,or immoral,but are these characterizations justified? After all,profit-maximizing,perfectly competitive firms follow precisely the same decision criterion as the monopolist:that is, MR = MC.Viewed in this way,it is difficult to sustain the argument that the evils of monopolies reside in the hearts of monopolists.

To evaluate the relative societal merits of perfect competition versus monopoly,a more objective standard must be employed.We may infer,for example,that a monopolist earning economic profit benefited at the expense of consumers.We have already noted that consumers are made worse off because monopolists charge a higher price and produce a lower level of output than would be the case with perfect competition.We have also noted that monopolies are inherently inefficient because monopolists do not produce at minimum per unit cost.The real issue is whether the gain by monopolists in the form of higher profits is greater than,less than,or equal to the loss to consumers paying a higher price from a lower level of output.If the gain by monopolists is equal to the loss by consumers,it will be difficult to objectively argue that society is worse off because of the existence of monopolies.After all,monopolists are people too.

There are a number of reasoned economic arguments favoring perfect competition over monopoly.One such argument involves the application of the concepts of consumer and producer surplus.Consider Figure 8.14,which illustrates the situation of a profit-maximizing monopolist.For ease of exposition,the marginal cost curve is assumed to be linear.

In the case of perfect competition,equilibrium price and quantity are determined by the intersection of the supply (marginal cost) and demand (marginal benefit) curves.In Figure 8.14 this occurs at point E.The equilibrium price and quantity are P* and Q*,respectively.As in Figure 8.13, consumer surplus is given by the area P*AE and producer surplus is given by the area BP*E.The sum of consumer and producer surplus is given by the area BAE.

Suppose that the industry depicted in Figure 8.14 is transformed into a monopoly.A monopolist will maximize profits by producing at the output level at which MR = MC.The monopolist in Figure 8.14 will produce Qm units of output and charge a price of Pm.The reader will verify that under monopoly the consumer is paying a higher price for less output.The reader will also verify that consumer surplus has been reduced from P*AE to

A

Pm P*

P0

B

Consumer surplus Income transfer

C

G MC

E

Consumer deadweight loss

Producer deadweight loss

F

D

0

Qm Q*

MR Q

FIGURE 8.14 Consumer and producer deadweight loss.

PmAC.Clearly,the consumer has been made worse off as a result of the monopolization of this industry by the area P*PmCE.To what extent has the monopolist benefited at the expense of the consumer?

An examination of Figure 8.14 clearly indicates that producer surplus has changed from the area BP*E to BPmCF.The net change in producer surplus is P*PmCG - FGE.The portion of lost consumer surplus P*PmCE captured by the monopolist (P*PmCE) represents an income transfer from the consumer to the producer.If the net change in producer surplus is positive,then the producer has been made better off as a result of the monopolization of the industry.Certainly,in terms of Figure 8.14,this appears to be the case,but is society better off or worse off? To see this we must compare the sums of consumer and producer surpluses before and after monopolization of the industry.

Before the monopolization of the industry,net benefits to society are given by the sum of consumer and producer surplus, P*AE + BP*E = BAE. After monopolization of the industry the net benefits to society are given by the sum of consumer and producer surplus PmAC + BPmCF = BACF. Since BACF < BAE,society has been made worse off as a result of monopolization of the industry.

DEADWEIGHT LOSS

The reader should note that in Figure 8.14 the portion of lost consumer and producer surplus is given by the area GCE + FGE = FCE.The area FCE is referred to as total deadweight loss.The area GCE is referred to as consumer deadweight loss.Consumer deadweight loss represents the reduction in consumer surplus that is not captured as an income transfer to a monopolist.The area FGE is referred to as producer deadweight loss.Pro-

ducer deadweight loss arises when society’s resources are inefficiently employed because the monopolist does not produce at minimum per-unit cost.No assumptions about the relative merits of consumers or producers or the distribution of income are required to assess this outcome.Clearly, the loss of consumer and producer surplus represents a net loss to society.

Definition:Consumer deadweight loss represents the reduction in consumer surplus that is not captured as an income transfer to a monopolist.

Definition:Producer deadweight loss arises when society’s resources are inefficiently employed because the monopolist does not produce at minimum per-unit cost.

Definition:Total deadweight loss is the loss of consumption and production efficiency arising from monopolistic market structures.Total deadweight loss is the sum of the losses of consumer and producer surplus for which there are no offsetting gains.

The importance of the foregoing analysis of the welfare effects of monopoly for public policy cannot be underestimated.Demands by public interest groups for remedies against the “abuses”of monopolies are seldom framed in terms of total deadweight loss,and indeed focus on the unfairness of the transfer,with monopoly pricing of income from consumer to producer,(i.e.,the net loss of consumer surplus).But as we have seen,part of this loss of consumer surplus is captured by the monopolist in the form of an income transfer.It is important,however,to question the disposition of income transfers before categorically condemning monopolistic pricing and output practices.

Monopolistic market structures that result in increased research and development,such as product invention and innovation,may be considered to be socially preferable to the rough-and-tumble of perfect competition. An example of this is monopolies arising from patent protection that results in the development of lifesaving pharmaceuticals.Another example of a monopoly that is considered to be socially desirable is that of the government franchise,which was also discussed earlier.The static analysis of the welfare effects of monopoly ignores the dynamic implications of monopolistic market structures.The dynamic implications must also be considered when one is evaluating the relative benefits of perfect competition versus monopoly. Problem 8.12. Consider the monopolist that faces the following market demand and total cost functions:

a.Find the profit-maximizing price (Pm) and output (Qm) for this firm.At this price–quantity combination,how much is consumer surplus?

Q = 22 P 5 TC Q Q = - + 100 10 2

b.How much economic profit is this monopoly earning? c.Given your answer to part a,what,if anything,can you say about the redistribution of income from consumer to producer? d.Suppose that government regulators required the monopolist to set the selling price at the long-run,perfectly competitive rate.At this price, what is consumer surplus? e.Relative to the perfectly competitive long-run equilibrium price,what is the deadweight loss to society at Pm?

Solution

a.The total revenue function for the monopolist is

The monopolist’s total profit function is therefore

Taking the first derivative of this expression yields the profit maximizing output level

The profit-maximizing price is,therefore

Consumer surplus may be determined from the following expression: Consumer surplus = 0.5(110 - Pm)Qm where 110 is the price according to the demand function when Q = 0.

Utilizing this expression yields Consumer surplus = 0.5(110 - 60)10 = $250 b.The monopolist economic profit is

which is the amount of the income transfer from consumer to producer. c.Unfortunately,economic theory provides no insights about whether this income transfer is an improvement in society’s welfare.Such an analysis would require an assumption about the appropriate distribution for the society in question,and this cannot be evaluated by using efficiency criteria. d.The perfectly competitive long-run equilibrium price is defined as P MC ATC = =

TR PQ Q Q = = -110 5 2

p=- + -100 120 6Q Q2

dp dQ = - = Q 120 12 0

Qm = 10

P Q m m = - = - ( ) = 110 5 110 510 60

p=- + - =- + ( ) - ( ) = 100 120 6 100 12010 6102 500 2Q Q $